As part of its ongoing campaign to see investors better
educated, RBE’s Mr Bond lifts the lid on some of the markets worst excesses - 'don’t take shareholder risks for bondholder rewards'

The previous article, “Not all bonds are born equal”
mentioned the Prospectus Directive, the basic rule book governing the issuance
of new securities to investors. Under the PD there are two types of bonds,
Corporate Bonds and Asset Backed Securities (“ABS”).

A Corporate Bond can be issued by any type of non-government
entity. The issuer will be a PLC, or the overseas equivalent, and will have two
years audited accounts. In some instance the issuer will be a new company,
likely a hold co., in which case the two years accounts will be provided by an
op co beneath it:

The key points here are:

-
The accounts provide information that allows
investors to judge the risks inherent in an issue, and provides the numerical
raw material for the financial covenants.

-
Should there be a default investors have access
to the issuer assets, except those specifically excluded by pledges, e.g. bank
guarantees, or mortgages.

The loan
originators are commonly referred to as the issuers of ABS, but in fact they
are the sponsors, not the direct issuers, of these securities.
These financial
institutions sell pools of loans to a special-purpose vehicle (SPV), whose sole
function is to buy such assets in order to securitise them, the SPV is the
actual issuer of the bonds.

The key points are:

Bondholders
have access only to the SPV’s assets, i.e. the securitised loans, referred
to as collateral, which are the only assets of the issuer. You should expect credit enhancement by
over-collateralisation.

Bondholders
are wholly dependent on the cash-flows from the collateral to service
coupons and the repayment of the loans underlying the collateral to repay
principal.

As a simple summary, a corporate
bond has two years accounts to support it, an ABS has hard assets, collateral,
to provide the cash-flows to service coupons, the collateral is
self-liquidating which provides the capital to redeem the bonds.

What we are seeing coming to
market fits into neither category, many of these firms are start-ups with no
financial history, often borrowing money to buy assets that ultimately
collateralise the issue.
New firms with no operating
companies to act as guarantor should not be issuing debt, if they need funds it
should be shareholder equity.

Equity investors, especially those looking at
smaller businesses expect risk, in return they expect rewards; a suitable
reward isn’t a 7% coupon it is the share price doubling or tripling.

All that
happens when these new businesses issue debt is all the risk is passed to the
bondholder, if they succeed the owner of the business still holds 100% of the
equity.

Mr Bond says, “no coupon can compensate for the risk
you are being asked to take”

Firms borrowing to acquire assets
run the risk of either not being able to do so, or rushing and buying
badly. If the issuer cannot acquire
assets, after a year they will have had to pay one or two coupons, if the
annual value of this is 7% then they will have diminished the bonds capital
begging the question, “how do they return 100”?

Alternatively, rushing to
acquire assets to service coupons can lead to mistakes meaning the assets may
not be of the quality to properly collateralise the issue.

Another thing we are seeing is
property linked bonds, often these bonds sit behind senior debt from banks; the
bond is junior and is a cheap way for developers to avoid expensive mezzanine
finance or having equity investors.

Not only are the bonds junior there may be
times when the underlying property values are not sufficient to collateralise
the bonds, especially if property prices slow down. Not only are bondholders
left unsecured they are being short changed; mezzanine finance can easily cost
12%+, and equity investors often expect IRR’s of 20%+.

In addition, Mr Bond says, there
are other warning signs to look for:

·
The Listing Venue: exchanges such as the LSE
will not allow issues such as this, especially in retail denominations, instead
they gravitate to listings such as Cyprus and Gibraltar: Mr Bond says, “Leave
these as places to go on holiday”.

·
Fees: the prospectus should show fees, either
broken down or as a total. Anything in excess of 5% is too much, issues over £30m
should be even lower. Also check to see how the percentage is calculated, e.g.
if it assumes an unfeasible size of issuance such as £50 or £100m. Mr Bond
says, “Fee levels such as this mean someone is being paid at bondholders’
expense. Good issues don’t need this level of fees”.

Not only aren’t all bonds born
equal, many should not be issued as debt; Mr Bond warns, “Don’t take
shareholder risks for bondholder rewards”.